Can we learn from the 1930s?

Liberal Democrat conference goers are shaping up to a confrontation in three weeks’ time over economic policy. On the one hand the leadership wants to defend the current coalition government’s record; on the other many activists feel that this policy has been a dismal failure. This confrontation has been brewing for some years. It reflects a wider controversy in the country at large, though one senses that most people are now moving on. In this argument it does not usually take long before the government’s critics refer to the experience of the 1930s recession, or Depression, to back up their case. It’s worth unpicking that a bit.

My main source on this is a pamphlet produced by the think tank Centre Forum: Delivering growth while reducing deficits: lessons from the 1930s by Nicholas Crafts published in 2011. This concentrates on the experience of the UK. The first thing to point out is that the UK experience of the Depression is very different from the US one, though they are often conflated when people refer to the Depression now (just as the current experiences of the UK and US get conflated, especially noticeable when critics of UK policy quote U.S economist Paul Krugman in their support). The U.S. suffered a banking collapse, which then caused a catastrophic collapse in the rest of the economy, with real GDP falling by as much as 36% (hitting bottom in 1931); it only got back to its 1929 level in 1940. Behind the US collapse was a structural transfer of economic activity from agriculture to manufacturing, which it took the war economy to complete. Britain’s crisis was much less severe; it suffered a major loss of exports and economic shrinkage, but no banking collapse. The economy hit bottom also in 1931, just over 7% down from 1929 and was back to 1929 levels in 1933; by 1940 it was over 20% ahead. By comparison with the U.S. the structural move from agriculture to manufacturing was much more advanced when the recession struck. Britain was, however, struggling to adjust to a world where it could not rely on its Empire to drive its economy.

In fact, after flatlining in 1930 and losing over 5% in 1931, the UK made rather a successful recovery from the recession, as Mr Crafts (a professor of economic history at Warwick University) points out. This was achieved in spite the government cutting expenditure and raising taxes – austerity policies in today’s talk. Mr Crafts is very clear as to why: loose monetary policy. Specifically interest rates where kept low, and the authorities persuaded people that inflation would be persistent (at about 4%), giving negative real interest rates, while the pound was allowed to devalue. Something similar happened in the U.S in the New Deal era. Mr Crafts suggests that this formula should be repeated now, if the Bank of England could credibly suggest that inflation would increase to about 4% for the medium term, instead of its 2% target. This is quite topical, as this is almost exactly the strategy of the current Japanese government, the so-called “Abenomics”.

One point of interest in this is the rival claims of “Keynesians”, who advocate fiscal stimulus (extra government expenditure) and monetarists, who advocate loose monetary policy – though quite a few, like Mr Krugman, advocate both. Both groups refer back the Depression for support. In fact fiscal stimulus was not much used in the 1930s, while loose monetary policy was. Fiscal stimulus only came into its own at the end of the 1930s and in the 1940s, when it was led by rearmament and provoked by fears and then the reality of war.

I must admit that I find the parallels with the 1930s, especially in Britain, to be entirely unconvincing. The one clear lesson I would draw is that a banking collapse, as happened in the US in 1929, can be catastrophic. The world’s authorities were absolutely right to head this off in 2008-2009, even if that leaves awkward questions over how we got into the mess in the first place. That lesson was well learned, but there the lessons pretty much end. Further lesson-drawing leans on a species of macroeconomic blindness, a sort inverse of the composition fallacies that macroeconomists like to accuse their critics of. This entails taking false confidence by examining a collection of aggregated statistics, dipping down only selectively into the realities that lie behind them.

Consider some important differences between the world of the 1930s to the 2010s, for Britain in particular:

Britain’s banking sector was in much better shape in the 1930s. It was less dominated by big institutions (there was a thriving building society movement) and these institutions had not overreached in the way they had in 2008. The main barrier to borrowing was lack of demand for loans, which lower real interest rates incentivised.

There were many fewer barriers to house building in the 1930s. The main source of investment in the 1930s recovery was private sector house building. It clearly helped then that there was a severe house shortage, and inflation encouraged people to bring forward building projects. There is a housing shortage now, of course, and to be fair Mr Crafts says that barriers to house building would have to be tackled. But more than planning barriers are involved here. There is the general zeitgeist around the future direction of property prices; this is largely founded on the idea of restricted supply. Currently developers are holding back on many projects not because of finance, or lack planning permission, but because of doubts over the future direction of property prices.

Nowadays we live in a world of highly integrated financial markets and global trade. This has changed the way fiscal and monetary policy work. It is by no means certain (and in my view highly unlikely) that loose monetary policy would work itself out in such a benign way as in the 1930s. Would inflation in fact increase? If it did would wages stay ahead of prices? And if wages did not stay ahead of prices would companies invest their profits so as to boost domestic demand? (There is a fascinating aside in Mr Crafts’s pamphlet here. In the 1930s the Treasury assumed that prices would indeed run ahead of wages, boosting corporate profits, which would boost the economy. In fact wages kept pace with prices and the domestic demand was behind the growth). And bumping up inflation would quite likely cause the price of government gilts to plummet, making it harder to finance the national debt: in this day and age it is not as easy to inflate your way out of debt as many economists assume.

And that’s just the start. The more you investigate and think about the rights or wrongs of different policies, the less relevant the 1930s looks. It is just as bad for fiscal policy. In the 1930s and 1940s rearmament was a useful outlet. It soaked up surplus labour quickly and led to the building of industrial capacity that, as it turned out, could be readily reassigned to more constructive and benign uses. And the threat of war was horribly real, allowing the public to be mobilised behind the dislocation of the civilian economy. I cannot see what the modern equivalent is. Rearmament now, even if you can find a wider justification, would require the wrong skills and capabilities. The building of social housing is a possibility, I think, but would be insufficient in its own right.

Indeed I think the real issue of substance that divides critics of the coalition from its supporters, among Liberal Democrats anyway, is whether there is a pool of £20 billion or so of capital projects that the government can immediately and profitably get in motion. In the 1930s and 1940s it was weapons. In the 2010s it is what?

4 thoughts on “Can we learn from the 1930s?”

Whence the assumption that only capital projects can get a country out of recession? Any old type of spending will do. Indeed, as Keynes pointed out in jest, even having people dig holes in the ground and fill them up all day long would do.

Moreover, while there may well be a good case for more infrastructure spending in the long term, infrastructure spending is PARTICULARLY UNSUITED to escaping a recession because by the time the infrastructure scheme gets going, the recession may be over.

Unfortunately it’s near impossible to get the latter very simple point into peoples’ heads. But I keep repeating the point online at least once a week. After all, civilisation is a race between education and catastrophe, as H.G.Wells put it. I’m doing my little bit for education.

That’s a long story Ralph – but it is a conclusion that most Lib Dem critics of government policy have come to, as well as such luminaries as Martin Wolf of the FT. It is also what Keynes himself was saying in 1945 – though that may just have been to make his idea more politically palatable. I have also developed the argument on this blog as the only type of stimulus that makes sense in Britain’s current context.

Each of these critics has a slightly different take on it. Mine is that the economy has become badly unbalanced, with the persistent balance of payments deficit as the main evidence. This has arisen through many years of deficit financing and over-borrowing (mainly private sector), which has pushed the exchange rate up, and hollowed out export industries apart from financial services, which is prone to sucking in huge resources every time there is a bust. The danger of blind stimulus is that it simply reflates the economy back into this unbalanced and unsustainable state, causing another bust (on this occasion probably provoked by government borrowing rather than the banking system) and ending up with the economy even worse than before. The argument for capital projects is twofold. First it can be reconciled with the rebalancing objective by investing in things that support that objective. Second, since capital projects will have a payback in future revenues, especially if borrowing is cheap, so it will not place undue stress on the nations finances.

However, you are right about the difficulty of capital projects. Mostly capital spending is too late or wasted on reckless projects that do not aid rebalancing or pay for themselves. This is a point that macroeconomic specialists, like Martin Wolf, seem to be blind to.

How about having all new buildings (residential and office) built to the Passive House standard (http://en.wikipedia.org/wiki/Passive_house)? High initial investment leading to future energy saving and a lower carbon footprint.

Building standards have been steadily raised and I’m sure this helps – the passive house standard would be another step on this path – but in this country there is something not right in the way be do housing. Developers are mainly motivated by the idea of making a quick profit on the sale of new housing. That makes them want to resist and evade measures like this to improve the quality of housing. And they are quite capable of sitting on good land without building on it until they think the profits are going to be big enough. If they built primarily for rent (as they did in the great Victorian housing boom) it would be a different matter. It’s one reasons why I am keen to promote (and even subsidise) social landlords.